Wall Street's major averages fell sharply on Tuesday as investors fretted over the prospects of higher interest rates.

The Dow Jones Industrial Average plunged 697.10 points, or 2.06 percent, to 33,129.59. The S&P 500 sank 81.75 points, or 2 percent, to 3,997.34. The Nasdaq Composite Index shed 294.97 points, or 2.5 percent, to 11,492.3.

The three major indexes booked their worst daily percentage declines since Dec. 15, according to FactSet data.

All the 11 primary S&P 500 sectors ended in red, with consumer discretionary and technology down 3.34 percent and 2.4 percent, respectively, leading the slide.

The Cboe Volatility Index, widely considered as the best fear gauge in the stock market, surged 7.72 percent to 22.87.

The market sell-off came as latest U.S. economic data fueled worries that interest rates will need to stay higher for longer to tame inflation.

A survey released Tuesday by S&P Global showed that flash U.S. manufacturing PMI (Purchasing Managers' Index) rose to 47.8 in February from the prior month's reading of 46.9.

The S&P Global flash U.S. services business activity index posted 50.5 in February, up from 46.8 in January, and signaled the first expansion in service sector output since June 2022.

Last week, the January U.S. Consumer Price Index and Producer Price Index showed inflation inching higher, dashing hopes of an early end to rate hikes.

"Concerns that the Federal Reserve will need to hike rates further and hold them there for longer appeared prominent in investors' minds," UBS analysts said in a note on Tuesday.

The Fed has raised its policy rate by 450 basis points since last March from near zero to a range of 4.5-4.75 percent. Top Fed officials have stressed that more needs to be done to curb inflation.

St. Louis Fed President James Bullard said last week that he pushed for a higher interest rate increase at the last meeting and could see a more aggressive move ahead.

Cleveland Fed President Loretta Mester said she "saw a compelling economic case" for a 50 basis-point increase at the recent meeting, noting the U.S. central bank has to be prepared to move higher if inflation remains stubbornly high.

Markets had been pricing in two 25 basis point interest rate hikes for this year, but recent data had investors to price in a potential third interest rate hike, according to strategists at LPL Financial Research.

"What has caught the market's attention, however, is the slight probability for a 50 basis point rate hike at the March meeting has been climbing higher," they said on Tuesday, adding that this week's release of the Fed's preferred inflation index, the Personal Consumption Expenditures Price Index, "will be especially important in forecasting the Fed's next policy decision."

The Fed on Wednesday is set to publish the minutes from its Jan. 31-Feb. 1 meeting.

U.S. financial markets were closed on Monday due to the Presidents' Day holiday.

For the trading week ending Feb. 17, the Dow slipped 0.13 percent, the S&P 500 fell 0.28 percent, and the technology-heavy Nasdaq rose 0.59 percent.

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